Depreciation of Lewis Driscoll and Delta Cargo - Case Study Example

Lewis Driscoll and Delta Cargo Executive Summary The report attempted to find out the most desirable method of depreciation to be adopted by the company. To determine this various factors like tax outflow, managerial bonus etc have been taken into consideration. Finally a recommendation has also been given on aspects like asset disposal. The depreciable cost of the crane has been computed after making the necessary adjustments relating to capital expenditures and deducting the expected salvage value of the crane from the total cumulative cost of the asset. The reason for the treatment of the various costs i.e. whether it is a capital or revenue expenditure has also been discussed. The depreciation of crane has been calculated using Straight Line method (SLM), Double Declining Balance (DDB). The impact of the depreciation expense on the earnings of the company has been shown. The depreciation as per tax-based modified accelerated cost-recovery system (MACRS) has also been computed. The impact of depreciation expense under the two methods- SLM and DDB- on the amount of bonus has been shown. It has been shown how a higher depreciation expense reduces the amount of managerial bonus whereas a lower depreciation expense increases the amount of managerial bonus. It has also been shown how the amount of depreciation charged impacts the tax outflow of the company. In fact the earnings are also affected by the choice of asset disposal. If the company disposes off the asset at a loss the resulting impact on earnings and bonus has also been shown. Table of Contents Table of Contents 2 Introduction 3 Determination of nature of cost 3 Factors guiding depreciation expense 5 Disposal of old forklifts 7 Impact on bonus 9 Exhibit 1- 10 Exhibit 2- 11 Exhibit 3- 12 Bibliography 14 Introduction Delta Cargo is planning to acquire a new crane which will improve the overall efficiency of the company’s operations. However there is some amount of uncertainty with the appropriate depreciation method to be used for the new asset. Ideally the amount of depreciation should be such that it helps the company in saving taxes. Although depreciation does not involve any cash outflow but the amount of depreciation affects the profitability of the company thereby impacting managerial remuneration. Determination of nature of cost In order to estimate the amount of depreciation one has to estimate the depreciable cost of the asset. When equipment is purchased the company has to incur various costs to put it into working conditions. While some of the costs are of capital nature the others are of a revenue nature. The capital expenses are added to the acquisition cost of the equipment to ascertain the depreciable cost of the asset and the revenue costs are shown as an expense in the profit and loss statement. The capital expenses incurred are mostly of higher amount. This kind of expenditure improves the earning capacity of the business and is generally a one-time expense. If the benefits from an expense are consumed within the same accounting period it is treated as revenue expenditure. On the other hand if the benefits are available for more than one accounting period it is regarded as a capital expenditure. In the estimation of depreciable cost of crane, expenses relating to Shipping, handling and assembling have been added with the cost of crane. This is because this is a ‘capital cost’ as it is a one time expense. The Additional in-house assembly cost of $20000 has also been treated as capital cost as this brings the crane into working condition (Hanif, 2001, p.8.3). This amount is paid to the employees of the company for assembling the parts of the crane; for this reason this has been treated as a capital expense (Hanif & Mukherjee, 2003, p.16.20). The training costs have been treated as revenue expense. In the company the training costs are incurred on an ongoing basis. This implies that it is not a one time expense. The one time expenses are treated as ‘capital expense’ but as the costs incurred on training are incurred by the company every year therefore this has not been added with the cost of asset in determining the depreciable cost of the asset. This has been treated as a revenue expenditure. The amount paid to Contract Operator of $5000 has been shown as a capital expense. This cost is being incurred for the consultant provided by J.M. Crane Company for one month. This cost is directly related to the crane and is a one time cost and hence has been shown as a capital expense. The amount paid as Severance for forklift has been shown as a revenue expense. This is a one-time expense but this cannot be directly attributed to the cost of the crane. For this reason this has not been added with the crane cost. The cost incurred on erecting support beams for the dock to enable it to withstand the additional weight of the crane has been shown as capital expenditure. These beams are expected to have a long life. This indicates that the benefits from such costs can be enjoyed for more than one accounting period. For this reason this has been shown as a capital expense. The amount incurred as Special paint work of $30000 has also been shown as a capital expense. This will protect the crane from rust due to moisture and salt. In other words it will enhance the working life of the asset thereby increasing its earning capacity. An expense that raises the earning capacity is treated as a capital expenditure. The amount spent on Delta Cargo stencil will also protect the crane from environmental factors thereby increasing its working life. An expenditure incurred for improving the condition of an asset is capitalized and is added to the asset cost. For this reason this amount has been show as a capital expenditure and added to the acquisition cost of the crane. Factors guiding depreciation expense The depreciable cost of the crane has been calculated as $2,148,000. This has been obtained after deducting the salvage value arising at the end of 10 years of $100000 from the cost of the asset i.e. after making the necessary additions relating to capital expenditure with the cost of acquisition of the crane. Under the Straight Line Method (SLM) the amount of depreciation is calculated by dividing the asset cost by the useful life i.e. by dividing $ 2,148,000 by 10 years. This comes to $214800. Under the double declining method the amount of depreciation is calculated by multiplying the asset’s book value by a rate which is generally double the rate obtained as per the straight line method (Albrecht et al., 2007, p.425). At the end of the asset’s estimated working life the amount in excess of the salvage value is shown as depreciation. The book value of the crane is taken as $2248000. The depreciation rate as per SLM is calculated to be 10%. The rate of depreciation under DDB is obtained by doubling the depreciation rate as per SLM. This is obtained to be 20% and this rate is kept fixed throughout the life of the asset except in Year 10. The depreciation shown as per DDB in the first year is $449600. In the tenth year the depreciation is shown as $201721. This is the amount in excess of the salvage value (Heintz & Parry, 2007, p.177). Another method of depreciation is the tax based Modified Accelerated Cost Recovery System (MACRS). Under this method the useful life of the asset is ignored. Here the assets are classified into various property classes. Unlike SLM the salvage value of the machine is not taken into account at the time of computation of depreciation (Shim & Siegel, 2007, p.218). In the absence of any information relating to property class the useful life of the assets of 10 years has been assumed to be the property class of the crane. Based on this the amount of depreciation for the first year is calculated as $224800. The amount of depreciation is highest as per DDB and is lowest as per SLM. If the amount of depreciation calculated as per DDB is taken into account then this will result in higher tax savings for the company. This is because depreciation is a tax deductible expense. It will help the company in lowering the tax burden i.e. it will lower the tax outflow. In other words it is good from the company point of view but it may not be in the interest of the managers of the company. Disposal of old forklifts The company has two options with regard to disposal of old forklifts. The company has 10 such forklifts. It can either dispose it of at $8000 each. But this may not be a very viable proposition as it will result in loss on asset disposal. The net book value of each old forklift is $12000. If the company accepts this offer there will be a loss of $4000 on each old forklift. The total loss on this disposal will be $40000. Journal entry- Date Details DEBIT ($) CREDIT ($) 2005 Dec 31 Option 1- Cash Loss on sale To Disposal of asset Being the old forklift sold at a loss. 80000 40000 1200000 The company has another option by way of which it can sell the old forklifts at a profit but for this the company has to wait for another year. For this the company has to spend an additional refurbishment cost of $6000 for each forklift but this will be reimbursed by the buyer. The amount that the buyer is ready to pay for the purchase is $14000. This will result in a net gain of $2000 on each forklift i.e. a total gain of $20000. Journal entry- Date Details DEBIT ($) CREDIT $) 20065 Dec 31 2006 Dec 31 Option 2- Refurbishment cost Cash Being the cost on refurbishment paid. Cash Gain on disposal Refurbishment costs reimbursed Disposal of asset Being the old forklift sold after one year on gain and the refurbishment costs reimbursed. 60000 200000 60000 20000 60000 120000 (Hosein, 1988, p.155). The first option is better as compared to the second option. This is because the latter involves incurring of refurbishment costs of $60000. The company can recover this cost after a year as the buyer of the forklifts will reimburse this cost. Even though the second option will result in a net gain of $20000 as compared to a net loss of $40000 in the first option, it is not desirable as this will have an impact on the liquidity resources of the company. The purchase of the asset will result in an immediate cash outflow and if the company has to spend more money on refurbishment it will exert a strain on the liquidity position of the company. Moreover the gain on disposal is also nominal. Based on this the first option looks more suitable. Impact on bonus The bonus for the managers of the company including Lewis Driscoll is calculated on the basis of the earnings before taxes (EBT). Therefore a high EBT will result in higher bonus for the managers and a low EBT will lower the amount of bonus. Suppose if the company charges a higher amount of depreciation to save on the taxes then the company stands to gain but the managers stand to lose as this will lower the earnings on which the bonus computation is done. But if the company shows a lower amount of depreciation then the tax outflow of the company will increase but the managers will be benefitted as their bonus will be computed on a higher amount of Earnings before taxes. Like if the company uses SLM the amount of depreciation of $214800 is less than the amount of depreciation under DDB of $449600. As a result of this the tax outflow in SLM is higher at $487708 whereas it is less under DDB at $405528. But the amount of bonus under SLM is $278690 which is higher than the bonus computed as per DDB of $231730. So from the managerial point of view the SLM method of depreciation is better as compared to DDB. The decision relating to asset disposal will also have an impact on the amount given out as bonus. If the company shows loss on asset disposal then this lowers the amount of earnings thereby lowering the managerial bonus. Again if the company sells the asset at a gain then this will raise the amount of business earnings thereby increasing the amount of managerial bonus. Like if the company records the loss on asset disposal of $40000 the earnings are reduced by an equivalent amount thereby lowering the amount of bonus. But if the company sells the old forklifts at a profit of $20000 in the next year then this will not have any impact on the profitability of 2005 but in the immediately next year the resulting gain will raise the amount of earnings and will also push up the amount of bonus. But again the things must be considered from the company viewpoint. Therefore the methods by way of which the company benefits the most must be adopted. For the company the charging of higher depreciation and immediate disposal of asset is favourable. Exhibit 1- Exhibit 2- Exhibit 3- Reference Albrecht, S.W. Stice, D.J. Stice, K.E. Swain, R.M. 2007. Accounting: Concepts and Applications. Cengage Learning. Hanif, M. Mukherjee, A. 2003. Financial Accounting. Tata McGraw-Hill. Hanif, M. 2001. Modern Accountancy. Tata McGraw-Hill. Heintz, A.J. Parry, W.R. 2007. College Accounting. Cengage Learning. Hosein, P. 1988. Principles of accounts. Heinemann. Shim, K.J. Siegel, G.J. 2007. Schaum's Outline of Financial Management. McGraw-Hill Professional. Bibliography Eisen, P. 2000. Accounting. Barron's Educational Series. Gross, J.M. McCarthy, H.J. Shelmon, E.N. 2005. Financial and accounting guide for not-for-profit organization. John Wiley and Sons. Marriott, P. Edwards, R.J. Mellett, J.H. 2002. Introduction to Accounting. SAGE. Stickney, P.C. Weil, L.R. Schipper, K. Francis, J. 2009. Financial Accounting: An Introduction to Concepts, Methods and Uses. Cengage Learning. Read More